The chart above is the equity curve of the Mandelbrot algorithmic trading program back-tested from March 30th to July 28th 2015. The notional start equity was €90,000, and the account balance at the end of the period was €135,720, allowing for commissions. This gives a profit of 50.80% for the four-month period. A creditable performance. Our job now is to ensure that the real-money accounts deliver that outcome in the future. We will be using the optimised parameters for the trading software that gave rise to the record above, but performance will be carefully monitored to ensure that assumptions remain valid, and adjustments may be made to the configuration of the software if that is deemed to be necessary.
Each bar in the chart represents the cumulative balance in the account on a daily basis. Gaps between the bars illustrate those days on which no trading took place. They show mostly weekends, as we do not hold positions from Friday to Monday, or indeed overnight, but Mandelbrot is also programmed not to trade on days when sharp, bi-directional volatility might be expected, as on US Non-Farm Payrolls day, or when a significant monetary policy statement is issued, by such as the Fed or the ECB.
Development of the OmiCron Mandelbrot software has been guided by the principles outlined in the OmiCron Forex Trading Manual, which is available from Amazon.
What is a draw-down?
Looked at together, the tops of the bars, while generally proceeding in a satisfactory upward direction, show what might be characterised as a serrated edge, such as would be found on a saw. The falls in the amount of account equity from the peaks to the troughs of this pattern are known as draw-downs. They indicate when a short-term loss, or series of losses, interrupts the upward growth of the account.
The chart above shows the small area that is highlighted by the dotted line box in the equity curve at the top. This indicates the magnitudes of two draw-downs (a new, higher, peak is necessary to complete the definition of the second draw-down, and that is only visible on the top chart). Both of them result from a series of losses, and the one on the right adds up to a total reduction of over €7800, or 5.9%, to the account balance at the time. In absolute terms, this is not small change. The reason it is so relatively large is because it occurs near the end of the period of trading – Mandelbrot does all its work in percentage terms, so as the account grows, so does the absolute value of any losing trades that take place (as well as profitable ones, of course).
Draw-downs are an inescapable fact of life in Foreign Exchange or in any other type of trading. The only person who is known not to have had draw downs was one Bernard Madoff. In his book, “The Man Who Stole $65 Billion”, Erin Arvedlund points out that this feature of Madoff’s hedge fund returns was one of the things that made investigators suspicious. So suspicious that they started the process that eventually wound up placing Bernie behind bars for operating a massive Ponzi scheme.
In order to trade successfully, the trader (or the algorithmic system that he or she uses), must be able to sustain a loss. The only imperative is that it should be within the risk tolerance of the system used.
In real-time, a draw-down such as the larger of those shown above can be difficult to handle on a psychological level. This particular one, as noted, involves no small amount of account equity, and it has taken over a week to play itself out.
That is why it is so important to focus on the longer term outcome of trading. A narrow emphasis on each day’s results is not good for peace of mind. Trades that result in nice profits bring a warm glow, and even a feeling of elation, but sustaining a draw-down like the one described, even though it is within the bounds of what is normal, can be a harrowing experience unless the longer term is the focus.